Asset Allocation Committee Outlook

The first quarter of 2021 brought what we expected: a new U.S. administration and a new fiscal stimulus; the beginnings of the global vaccination program that should ultimately consolidate the re-opening of our economies; improving economic data worldwide; outperformance from commodities and from small-cap, value and cyclical stocks, with occasional volatility concentrated in large-cap growth; and a sell-off, albeit stronger than we anticipated, in Treasuries. As it looks to the next six to 12 months, the Asset Allocation Committee (“the AAC” or “the Committee”) faces two questions. Do we think the economy will overheat, pushing bond yields to levels that unsettle equity markets or even force central banks to stifle the recovery? And have markets moved enough to justify some rebalancing of last quarter’s views? Our answers are “no” and “yes,” respectively, but we maintain a hawkish eye on the economic data—and particularly the inflation thermometer.

In our last Asset Allocation Committee Outlook, our main concern was the high levels of optimistic consensus. We followed the consensus with our positive views on commodities, small caps, value and cyclical stocks, and with our concerns over the vulnerability of core government bonds. We expressed those views moderately, however, as we thought there was still enough uncertainty and potential volatility to offer “more opportunities to lean into the recovery as it develops.”

We got the outperformance from “recovery assets” and the sell-off in Treasuries that we expected. We also got the volatility—equity markets stumbled at the end of January and again at the end of February. Where we were surprised, it was by the speed and extent of the rise in Treasury yields and the relative shallowness of the equity market dips.

This is an important dynamic, as it tells us a lot about the forces behind the AAC’s first big question: How likely is it that Treasury yields could run out of control?

Since closing at 52 basis points on August 4 last year, the U.S. 10-year Treasury yield has risen rapidly to its recent high above 1.75%. More than half of this move has come in the past three months. While that has knocked several percentage points from the value of many fixed income portfolios, and reintroduced some volatility into equity markets, particularly among longer-duration large-cap growth stocks, it has not stopped the S&P 500 Index from reaching record highs.

Rising interest rates can have a negative effect on the valuations of risky assets, but that is not always the case because the main cause of higher rates is not always the same. Long-term rates are chiefly determined by expectations for economic growth, expectations for inflation and the level of uncertainty about the future path of short-term rates. History suggests that risk assets tend to fare poorly when yields rise as part of the tightening of financial conditions associated with new uncertainty about monetary policy, as they did during the “Taper Tantrum of 2013.” When they rise because of stronger growth and closing output gaps, however, as they did during the winter of 2001, the summer of 2003, the spring of 2011 and the winter of 2010 – 11, risky assets have tended to perform well or at least maintain their levels.

For the next two or three years, we anticipate above-trend economic growth, supported by fiscal stimulus, high household savings, robust corporate balance sheets and the changed consumption patterns associated with a likely continuation of “hybrid” on-site and remote working. The Federal Reserve recently revised its 2021 U.S. growth forecast up to 6.5%, in line with the OECD’s new projection, following confirmation of the Biden administration’s new fiscal stimulus. At the same time, overall financial conditions are likely to remain exceptionally easy. Even Treasury yields at today’s higher levels remain low by historical standards, while equity markets are buoyant and credit spreads are tight.

The Rapid Rise in Nominal Treasury Yields Has Not Tightened Overall Financial Conditions

 

With growth rates high, financial conditions accommodative and output gaps closing, we anticipate higher inflation over the next few years—in line with the 2.0 – 2.5% levels seen in some years following the financial crisis.

The Federal Reserve reasserted at its March policy meeting a commitment to targeting long-run average inflation of 2% rather than a current rate of 2%, and a determination to respond to actual economic data rather than forecasts—including forecasts implied in financial markets. Taken together, this gives us a “reactive” central bank as opposed to the old, “pre-emptive” model. Before it tightens policy, it appears that the Fed will need to see very strong evidence that inflation is problematically high, in the 3 – 4% range, and structural rather than temporary.

So far, the Treasury market has not priced for this kind of outcome. Some of the more volatile, short-term market-derived inflation expectations have risen above 2.5%. For comparison, however, the five-year breakeven inflation rate starting in five years’ time, which is the Federal Reserve’s favored indication of the market’s long-run average inflation expectations, is still only just above 2%.

In addition, the uniqueness of the current environment is likely to give the Fed exceptional latitude to stay on the sidelines. We believe the low base set last year makes it much easier to dismiss high inflation this year as a statistical aberration. A dearth of spending on services in 2020 is likely to be contrasted with a splurge of pent-up consumption in the summer of 2021. A spree on durable household goods and computer equipment in 2020 is likely to be contrasted with indulgence on holidays and nights out in 2021. Most banks and many corporations and consumers are coming out of recession with unusually robust balance sheets. When the economic data is so abnormal, not acting upon it is easily presented as prudent.

Long-Run Average Inflation Expectations Remain Close to the 2% Target Even as Medium-term Expectations Rise

 

Putting all of this together, there is consensus on the Committee on three important points.

The first is that the sell-off in nominal Treasuries may have happened faster than is warranted by current conditions; we anticipate more two-way trading and less momentum in Treasuries from now on. In particular, we believe a U.S. 10-year yield in the current range is high enough to attract euro- and yen-based investors, which is likely to be a significant headwind to much higher rates.

The second is that, even if the U.S. 10-year yield were to push to 2% or higher, that alone would be insufficient to elicit more hawkish rhetoric from the Fed; by contrast with the 2013 “Taper Tantrum,” we think 2021 will be remembered for its “Taperless Tantrum.”

And the third point of consensus is that the Fed is likely correct to forecast a spike in inflation this year followed by a return to 2.0 – 2.5% thereafter.

Consensus does not mean unanimity, and every Committee member emphasizes the importance of a close watch over the economic data. Over the coming months, some of that data could hit levels unseen for 40 or 50 years, unsettling markets. On the whole, however, those three assumptions underpin this quarter’s decisions on our asset allocation views.

These assumptions support a continuation of our pro-risk and pro-cyclical stance. The improving growth outlook is feeding into earnings forecasts: for the S&P 500, the analysts’ consensus is now for $200 per share this year, up more than 40% on 2020’s results. Were the 10-year U.S. Treasury yield to top out below 2.25%—a level we faced in early summer 2019, when the U.S. was growing at 2.2% rather than 6.5%—the effect on valuation multiples would be highly unlikely to wipe out the big boost to earnings.

As such, we maintain overweight views on equities and credit over core government bonds; U.S. small caps over large caps; non-U.S. over U.S. equities; and commodities and private markets over hedged strategies. The Committee continues to favor cyclical over defensive sectors and value over growth stocks.

That said, markets have moved decisively, consistent with these views over the past two quarters. As well as the jump in Treasury yields, 12-month trailing performance data in general is beginning to show remarkably big numbers. As of March 31, 2021, The Russell 2000 Index of small caps is up almost 95% over that period, almost 35 percentage points ahead of the Russell 1000 Index. The Russell 1000 Growth Index still leads the Russell 1000 Value Index over 12 months, but the Value Index has already raced ahead by more than 10 percentage points since the start of 2021. The Bloomberg Barclays Global High Yield Index is up almost 25% over 12 months, versus less than 5% from the Global Aggregate Index. The price of copper has doubled.

That brings us to our second question: Have markets moved enough to justify some rebalancing of last quarter’s views?

We have seen enough to change a few of our headline views. The AAC has moved investment grade fixed income up from an underweight to a neutral view: we have upgraded what we regard as oversold Treasuries, and even as spreads have tightened on high grade credit, we recognize new opportunities in some longer-duration bonds as a result of higher yields. The pronounced underweight view on non-U.S. developed market debt has also been eased, given the move in yields.

For the most part, however, our views might infer more subtle changes to asset allocation weights, depending on the balance within individual portfolios. For example, if the outperformance of small caps, value, non-U.S. markets, high yield and commodities has tipped these exposures out of balance, then taking profits on the margin may appear prudent, particularly as long-duration exposures such as nominal government bonds and large-cap growth stocks look less vulnerable to us now than they did before the recent run-up in rates. Overall, however, we are staying the course with our key views from the start of the year.

We also continue to anticipate potentially pronounced periods of volatility, which could be used to lean portfolios further into pro-recovery allocations as the year unfolds. While the Fed’s firm messaging may reduce some uncertainty, economic data surprises could increase it; and the Committee notes a range of other live risks, from a flare-up in relations with China to a taxation sticker shock, an attack on the U.S. Congressional filibuster or a partisan tussle over the third-quarter U.S. debt ceiling.

For now, it appears that the leading concern for investors is the recent momentum behind Treasury yields and what it implies for inflation and the trajectory of central bank policy over the next 12 to 24 months. The temperature is rising, and the summer could bring some very hot data. Like other summer heatwaves, we expect this one to be the topic of a lot of conversation, but cause only temporary discomfort—although we will be keeping a very close eye on the thermometer.